Class 11 Consumer Equilibrium and Demand: Complete Concepts and Practice

Big picture

Microeconomics studies the choices of individual units: a consumer, a firm, a market. This chapter is about the consumer: with a limited income, how does a consumer decide what to buy so as to get the most satisfaction? The answer gives us consumer equilibrium, and from it the demand curve, which shows how much of a good people buy at different prices.

We begin with the economy's basic problem of choice (the production possibility curve), then study consumer equilibrium in two ways (utility analysis and indifference curves), and finish with demand and its elasticity. Diagrams and numericals are central.

Learning goals

• Explain microeconomics and macroeconomics, the central problems of an economy, and the production possibility curve.

• Explain total and marginal utility, the law of diminishing marginal utility and consumer equilibrium by utility analysis.

• Explain the budget line, indifference curves and their properties, and consumer equilibrium by indifference curve analysis.

• Explain demand, its determinants and the law of demand.

• Distinguish movement along and shift of the demand curve; normal and inferior goods; substitutes and complements.

• Calculate price elasticity of demand by the percentage and geometric methods, and explain its determinants.

Core ideas

1. Microeconomics basics

• Microeconomics studies individual economic units (a consumer, a firm, a market). Macroeconomics studies the economy as a whole (national income, unemployment, inflation).

• Central problems of an economy: because resources are scarce and have alternative uses, every economy must decide what to produce (and how much), how to produce (labour-intensive or capital-intensive techniques), and for whom to produce (how output is distributed).

Production possibility curve (PPC). It shows the different combinations of two goods an economy can produce with given resources and technology, using all resources fully and efficiently.

Marginal rate of transformation (MRT) = units of one good sacrificed to produce one more unit of the other. It rises along the PPC because resources are not equally efficient in producing both goods, which makes the PPC concave to the origin.

• A point on the PPC means full and efficient use of resources.

• A point inside it means unemployment or inefficient use of resources.

• A point outside it is unattainable with present resources.

• The PPC shifts outward with growth of resources or better technology, and inward if resources are destroyed (for example, by a natural disaster).

2. Utility analysis

Utility is the want-satisfying power of a good.

• Total utility (TU): total satisfaction from consuming a given quantity.

• Marginal utility (MU): additional satisfaction from one more unit: MUn = TUn − TUn−1.

Law of diminishing marginal utility: as a consumer consumes more units of a good, the marginal utility from each additional unit falls.

TU is maximum when MU = 0, and falls when MU becomes negative.

Consumer equilibrium: one good. The consumer buys up to the point where MU (in rupees) = Price. If MU > P, buying more adds more satisfaction than it costs; if MU < P, the consumer buys less. Example: with the MU values above measured in rupees and a price of ₹4, the consumer buys 4 units (MU = 4 = P).

Consumer equilibrium: two goods. The consumer is in equilibrium when

MUx ÷ Px = MUy ÷ Py (= MU of money)

meaning the last rupee spent on each good gives equal satisfaction, and the whole income is spent. If MUx/Px > MUy/Py, the consumer shifts spending towards X until the ratios are equal.

3. Budget line

The budget line shows all combinations of two goods a consumer can buy by spending the entire income at given prices: Px × X + Py × Y = M.

Example. Income M = ₹100, Px = ₹5, Py = ₹10. If all is spent on X: 100 ÷ 5 = 20 units; on Y: 100 ÷ 10 = 10 units. The budget line joins (20, 0) and (0, 10). Its slope = −Px ÷ Py = −5 ÷ 10 = −0.5: to buy one more unit of X, the consumer gives up half a unit of Y.

The budget set is all combinations on or inside the budget line (affordable bundles).

Changes in the budget line

4. Indifference curves

An indifference curve (IC) shows all combinations of two goods that give the consumer the same satisfaction. A set of ICs is an indifference map.

Marginal rate of substitution (MRS): the rate at which the consumer is willing to give up good Y to get one more unit of X, keeping satisfaction the same: MRS = ΔY ÷ ΔX. MRS diminishes along an IC, because as a consumer has more of X, they are willing to give up less of Y for each extra unit of X.

Monotonic preferences: a consumer prefers a bundle with more of at least one good and no less of the other.

Properties of indifference curves

1. Slope downward from left to right: to get more of X, the consumer must give up some Y to stay equally satisfied.

2. Convex to the origin: because MRS diminishes.

3. A higher IC gives higher satisfaction (monotonic preferences).

4. Two ICs never intersect: if they did, one point would give two different levels of satisfaction, which is contradictory.

5. Consumer equilibrium: indifference curve analysis

The consumer reaches equilibrium at the point where the budget line is tangent to the highest attainable indifference curve. At this point:

• MRS = Px ÷ Py (the slope of the IC equals the slope of the budget line); and

• the IC is convex, so MRS falls as more X is bought.

If MRS > Px/Py, the consumer values X more than its market cost and buys more X; if MRS < Px/Py, buys less X. Equilibrium is where the two are equal.

6. Demand and its determinants

Demand is the quantity of a good a consumer is willing and able to buy at a given price during a given period.

Determinants of individual demand (demand function: Dx = f(Px, Pr, Y, T))

• Price of the good itself (Px)

• Prices of related goods (Pr): substitutes and complements

• Income of the consumer (Y)

• Tastes and preferences (T)

Market demand also depends on the number of buyers, distribution of income and expectations of future prices.

Related goods

Normal and inferior goods

7. Law of demand

Other things being equal, the quantity demanded of a good falls when its price rises, and rises when its price falls. The demand curve slopes downward.

Reasons:

• Law of diminishing marginal utility: consumers buy more only at a lower price, since each extra unit gives less satisfaction.

• Substitution effect: when a good becomes cheaper, it becomes relatively cheaper than substitutes, so consumers switch to it.

• Income effect: a fall in price raises the consumer's real income (purchasing power), allowing more purchases.

• New consumers: a lower price brings in buyers who couldn't afford it before.

• Different uses: a cheaper good is put to more uses (cheaper electricity used for heating as well as lighting).

Market demand is the sum of all individual demands at each price (horizontal summation of individual demand curves).

8. Movement along and shift of the demand curve

Examples of shifts: a rise in consumers' income shifts demand for a normal good to the right; a rise in the price of coffee shifts demand for tea (a substitute) to the right; a rise in the price of cars shifts demand for petrol (a complement) to the left.

9. Price elasticity of demand

Price elasticity of demand (Ed) measures how much quantity demanded responds to a change in price.

Percentage method: Ed = Percentage change in quantity demanded ÷ Percentage change in price, or Ed = (ΔQ ÷ ΔP) × (P ÷ Q).

Example. When the price of a good falls from ₹10 to ₹8, quantity demanded rises from 100 to 130 units.

% change in Q = (130 - 100) / 100 x 100 = 30%
% change in P = (8 - 10) / 10 x 100 = -20%
Ed = 30 / -20 = -1.5

The minus sign shows the inverse relationship; we usually compare the absolute value: 1.5, so demand is elastic.

Geometric (point) method: for a straight-line demand curve, Ed at a point = Lower segment ÷ Upper segment of the demand curve (measured from that point to the X-axis and Y-axis). At the mid-point Ed = 1; above it Ed > 1; below it Ed < 1; at the Y-axis Ed = ∞; at the X-axis Ed = 0.

Determinants of price elasticity

A reliable problem-solving routine

1. For the PPC, calculate MRT as the change in one good per unit change in the other; a rising MRT gives a concave PPC.

2. For utility, calculate MU = TUn − TUn−1; equilibrium where MU = P (one good) or MUx/Px = MUy/Py (two goods).

3. For the budget line, find the intercepts M ÷ Px and M ÷ Py, and slope −Px/Py.

4. For demand questions, decide whether a change is in own price (movement) or another factor (shift).

5. For elasticity, compute percentage changes using the original values, then compare with 1.

Connections that matter

• Producer behaviour and supply studies the other side of the market.

• Market price determination combines demand and supply.

• Correlation: price and quantity demanded show negative correlation.

Common mistakes

• Calling a change in income a movement along the demand curve. It is a shift.

• Saying ICs can intersect.

• Writing the equilibrium condition as MRS = Py ÷ Px. It is Px ÷ Py.

• Calculating percentage change on the new value instead of the original.

• Calling the PPC convex. It is concave to the origin because MRT increases.

Revision checklist

• I can explain central problems and draw and interpret a PPC with MRT.

• I can explain TU, MU, the law of DMU and consumer equilibrium by utility analysis.

• I can draw a budget line, find its slope and show the effect of changes.

• I can explain ICs, MRS, their properties and consumer equilibrium.

• I can explain the law of demand, its reasons, and movement versus shift.

• I can calculate price elasticity and explain its determinants.